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Liquid nightmares

Liquid nightmares

"In a world where money is being printed on an industrial scale, best recorded with scientific notation."

A recent article in The Telegraph grabbed my attention. It could serve as a modern day finance story within the collection of Aesop’s Fables.1

The headline: “How 370 investors lost £18m- in minutes” described the plight of the currency spread investors saw after the Swiss National Bank abandoned its peg against the Euro. Levered as much as 100-to-1, investors were hoping to score big wins with little upfront. While the dangers of levered investing are nothing new, what captured my attention was how markets known for being extremely liquid (foreign exchange trading averaged $5.3 trillion/day in April 2013 according to the BIS)2 were desiccated within seconds. The real story is not the pursuit of quick profit using leverage. Instead, it is a story about the transformation of a market in which buyers and sellers are numerous and the spread between bid and offer prices is small. In other words: a very “liquid” market.

In a world where money is being printed on an industrial scale, best recorded with scientific notation, the idea that there is a dearth of money on the opposite side of a trade is hard to believe. To the observant, signs something is amiss are clear. Problems that can stem from a lack of liquidity are numerous cites the Center for Financial Stability (CFS). Here’s evidence:

Exhibit one: the volatility of the US Treasury market in October 2014. According the CFS the bond market exhibited “a six standard deviation move in less than two hours, a move that happens once in 506,797,346 days.”3 For those of you without a calculator handy, that is once in 1.38 million years.

Exhibit two: the aforementioned currency market. The CFS cites problems with liquidity in trading G10 currencies, specifically questioning the reliability of prices quoted in the foreign exchange market. Additionally, last month’s Global Financial Stability Report by the International Monetary Fund noted problems with foreign exchange liquidity in the aftermath of the Swiss National Bank currency action.

Exhibit three: the receding liquidity in the fixed corporate bond market as evinced by “debt holdings by primary dealers are down by 80% since a peak in 2013.”4

Thinning liquidity is also being seen in parts of the commodity markets. In a previous In Focus, we noted the lack of liquidity in the crude oil market as swap dealers reduced their activity. It prompted producers to go directly to the derivative markets to sell their production, which caused further pressure on the commodity price.

The reasons for the decline in market liquidity include: structural changes in the repo market, regulatory changes to the level of capital banks need to carry to support their various activities and the businesses banks can operate in under the Volker Rule which is part of the under-construction Dodd-Frank Act.5 Each of these has had an impact on the ability and willingness of banks to engage in market making activities that inject liquidity into markets.

1 The Telegraph April 29, 20152 Data from the Bank of International Settlements Triennial Central Bank Survey, Foreign exchange turnover in April 2013 preliminary global results, September 20133 “Liquidity Shortage: Houston, We Have a Problem”, Center For Financial Research, February 25, 20154 Ibid.5 The decline in financial market liquidity, Barclays Research, February 24, 2015

Hans Olsen, CFA Global Head of Investment Strategy

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